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An unexpected systemic risk in exchange-traded funds has just been brought to light in a research note from credit ratings agency Moody’s, which says a recent trade by a large investor caused a breakdown in an ETF and left investors nursing losses.

The research note, which was published this week, says investors in an ETF provided by State Street saw the value of the investors' holdings drop by more than a percentage point below the value of the index the ETF was tracking, after a large investor, probably a hedge fund, redeemed a $780m block of the ETF's shares.

The trade took place earlier this month. The note describes how the huge trade caused a breakdown in the mechanism behind physical ETFs.

This mechanism relies on there being two ways to trade in ETF shares. In the primary market, investors buy blocks of 100,000 shares in the ETF for payment "in kind", that is, whatever asset the ETF is tracking. In the secondary market, investors buy shares in the ETF for cash. If the price in the secondary market goes above the price of the asset being tracked, the creation of blocks of shares in the primary market brings the prices back into line.

Moody's research note identified an occasion this month when two large trades in the primary market caused this mechanism to break down. On May 10, the research note said, State Street Global Advisor’s high yield bond exchange-traded fund, the SPDR Barclays Capital High Yield Bond ETF, experienced an in-kind redemption of 19.7 million shares, worth $780m. Shortly after, a further 14.4 million shares were redeemed in the primary market.

Moody's research note said: "In the face of this selling pressure, the fund’s price declined 2.7%, and its price to net asset value ratio sharply dropped to a discount of 127 basis points [that is, the ETF share price was trading 1.27% below the price of the Barclays bond index it was trying to track] on 17 May. This collapse in premium would have cost an investor a substantial portion of the year-to-date total return of the ETF."

The sale in the primary market was conducted by what Moody's referred to as "institutional investors", which may include hedge funds. The research note said: "Whatever the reason, retail investors in ETFs generally do not expect this type of trading behaviour.

"ETFs have been aggressively marketed to retail investors, [but] the rising use of ETFs as rapid trading vehicles by institutional block-traders and hedgers seems to be increasing investors’ risk. This development dilutes the marketing message."

Moody's said this development has the power to undermine the "credit positive benefits" ETF providers have enjoyed from their success to date: "The rising institutional use of ETFs is credit negative for ETF [providers], because retail investors and their advisers would be deterred from holding ETFs if they are exposed to elevated volatility and execution risk from large trades."

It also invites additional regulatory oversight. Moody's said: "In addition, such transactions elevate the potential for additional regulatory scrutiny and increased compliance costs for these products if their use as vehicles for implementing arbitrage strategies proves to amplify systemic risks."

Scott Ebner, global head of ETF product development at State Street Global Advisors, said: “Whether there is a causal link between the large trades and the discount is unclear to me; I would not expect there is one. I don’t think investors are being exposed to ‘elevated volatility from large trades'.

“It is normal for there to be a discount or premium during the day; what we expect is that it will not be significant or persistent. There are lots of reasons for discounts and premia to appear, the most important of which is the timing difference that arises because the net asset value price is made only once a day, at the end of the day. If investors want to get the market price, the ETF is the best way to do it.”